Innocent barriers are naturally made and can arise from scale economies or absolute cost advantages of incumbent firms. That means that an entrant into the market would face a higher average cost curve than the incumbent being longer in the market and having more experience what allows him to cut costs. The entrant is therefore not able to produce as efficiently and cheaply. This then works as disincentive to enter the market. Other examples of such barriers are cultural differences (e.g. Kosher food or Halal butchers) or geographic isolation (bus service in rural areas).
Strategic or behavioural barriers arise from purposeful and deliberate actions by an incumbent. Examples for these are brand loyalty and product differentiation which are products of deliberate actions by the monopolist or the marketing strategies used to establish the product. So do people, for instance, call a vacuum cleaner “hover” even though that is a company’s name and not the general term for the machine used to clean carpets. That shows how well a product’s name can be absorbed and established. Another strategic entry barrier are aggressive tactics including price wars, advertising campaigns or the creation of new brands. If innocent barriers are incomplete or inefficient a monopolist can engage in these strategic entry-deterrent measures such as a price war including limit pricing
Limit Pricing as entry barrier
That exploits the incumbent’s advantage of having lower unit costs compared to an entrant. The monopolist lowers the price to a level where the entrant is unable to earn supernormal profit leaving him with either normal profit or even losses. If the threat of losses or of inability to gain supernormal profit prevents the potential entrant from actually entering the market the barrier sustains the monopolist’s profit.
Barriers to exit are costs firms face when leaving a market. Not only do they impose costs on firms that once they entered the market have little choice but to “stay and fight” when market conditions deteriorate in order to avoid these costs, but they also give signals to firms considering a market entry. The higher these barriers are, the fewer firms will enter the market as the possible loss in case of failure is too high.
Examples for exit barriers are closure costs that include redundancy costs, contract contingencies with suppliers or penalty costs for ending leasing arrangements for property, or the loss of business reputation or consumer goodwill. Deciding to leave the market can seriously affect goodwill among previous customers being left with a product which is withdrawn from the market and for which replacement parts become difficult or impossible to obtain. That may influence the firm’s performance in a different industry. The most important exit barrier, however, seems to be sunk costs, unrecoverable costs that need to be invested to set up and establish the business such as costs for advertising, marketing or research which cannot be carried forward into another market.
In the short run barriers to entry and exit sustain monopolist behaviour and monopolistic profit. With time, however, these barriers begin to erode due to globalisation, technical changes and customised products and the market becomes more contestable. So do economies of scale, for instance, disappear with time as companies become too big, bureaucratic and inefficient or so does technology not only give monopolists an advantage but also potential entrants.
To keep control and prevent entries in the market it is essential that the monopolist controls sunk costs. That is the only way of sustaining control over the market and thus supernormal profit. Keeping these as high as possible is a very effective way of discouraging potential competitors from entering the market due to the risk of huge unrecoverable costs they would face when leaving a market they could not succeed in. To do so a monopolist could largely invest into advertising forcing any potential entrant to match this expenditure to establish himself in the market and exposing him to high unrecoverable costs in case of failure.
References
Economics, David Begg
McGraw Hill, 7th Edition 2003
http://www.tutor2u.net/economics/content/topics/monopoly/barriers_to_entry.htm
http://www.mises.org/fullstory.asp?control=509